Understanding Transfer Pricing in Related-Party Dynamics

Transfer Pricing Regulations govern how multinational enterprises (MNEs) price transactions between related entities in different tax jurisdictions. These regulations aim to prevent tax avoidance by ensuring that profits are not artificially shifted to low-tax jurisdictions. This article provides a comprehensive analysis of transfer pricing regulations in India and compares them with those in related jurisdictions, including the US, UK, and Singapore.

It is important to note that transfer pricing itself refers to a tax avoidance strategy employed by MNE groups by setting transfer prices that deviate from arm’s length prices.

Transfer Pricing Regulations in India

India introduced transfer pricing regulations in 2001 to prevent tax base erosion and ensure that cross-border transactions between associated enterprises are conducted at arm’s length. The primary legislation governing transfer pricing in India is Chapter X (Sections 92 to 92F) of the Income Tax Act, 1961, read in conjunction with Rules 10A to 10THD of the Income Tax Rules, 1962.

Key Provisions of the Indian Transfer Pricing Regulations

• Section 92: This section mandates that income from international transactions be computed with respect to the arm’s length price.
• Section 92A: Defines “associated enterprises” as two or more enterprises with participation in the management, control, or capital of each other, or with common management, control, or capital exercised by some persons.
• Section 92B: Defines “international transaction” as a transaction between two or more associated enterprises where either or both are non-residents. This includes transactions such as purchase, sale, lease, provision of services, lending or borrowing money, and cost contribution arrangements.
• Section 92C: Prescribes methods for determining the arm’s length price, including the Comparable Uncontrolled Price (CUP) method, Resale Price Method (RPM), Cost Plus Method (CPM), Profit Split Method (PSM), Transactional Net Margin Method (TNMM), and “Other Method.”
• Section 92D: Requires the maintenance of documentation to determine the arm’s length price, as prescribed in Rule 10B.
• Section 92E: Mandates an audit report from an accountant in a prescribed format (Form 3CEB) to be furnished by the entity undertaking an international transaction or a specified domestic transaction.

Applicability of Transfer Pricing Regulations

Transfer pricing regulations in India apply to both international and specified domestic transactions. Specified domestic transactions are those defined in Section 92BA, where the aggregate value exceeds INR 20 crores (approximately USD 2.7 million). These include transactions between different sub-units of an entity claiming a tax holiday and transactions between an entity claiming a tax holiday and a closely connected person.

Arm’s Length Price Determination

The arm’s length price is the price that would be charged in a transaction between independent enterprises under similar circumstances. India adopts the “most appropriate method” for determining the arm’s length price, considering the nature of the transaction and functions performed by the entities involved.

The arm’s length range concept was introduced in 2014, adopting the 35th to 65th percentile as the acceptable range. If the difference between the arm’s length price and the actual price falls within a specified tolerance range, the transaction is considered to be at arm’s length.

The tolerance range is determined based on several factors, including:

• Economic conditions: Broader economic factors like inflation, exchange rates, and economic stability can influence the tolerance range.
• Industry standards: Different industries have unique cost structures and price variations, which are considered when establishing a reasonable tolerance range.

The tolerance range offers several benefits:

• For businesses: It provides certainty and predictability, reduces compliance risks, and facilitates better resource allocation for transfer pricing compliance.
• For tax authorities: It streamlines audits, reduces administrative costs, and allows authorities to focus on higher-risk transactions.

Advance Pricing Agreements (APAs)

An APA is an agreement between a taxpayer and the tax authorities that determines the arm’s length price or specifies the method for determining it for a set of transactions over a fixed period. APAs provide certainty in tax positions, reduce compliance costs, and minimize the risk of future disputes. In India, APAs typically cover five years and may include a rollback provision for four preceding years.

Documentation and Compliance

Taxpayers must maintain comprehensive documentation to support the arm’s length nature of their transactions. This includes a description of the transaction, pricing methodologies, comparability analyses, agreements, financial data, and other relevant information. An accountant’s report in Form 3CEB must be filed annually, certifying the arm’s length nature of the transactions.

Penalties for Non-Compliance

Non-compliance with transfer pricing regulations can result in penalties, including:

• 2% of the value of the international transaction for failure to maintain documentation or furnish information.
• 50% to 200% of the tax payable on under-reported income.
• 100% to 300% of the tax amount on transfer pricing adjustments if deemed to be concealment of income.

In addition to penalties, taxpayers may face disputes with tax authorities. However, there are alternative dispute resolution mechanisms available, such as:

• Safe Harbour Rules: These rules provide circumstances under which the tax authorities will accept the transfer pricing declared by the taxpayer.
• Advance Pricing Agreements (APAs): As discussed earlier, APAs offer a proactive approach to resolving transfer pricing issues and achieving certainty.

OECD Guidelines and Applicability in India

While India is not an OECD member, its transfer pricing regulations are broadly aligned with the OECD Transfer Pricing Guidelines. The OECD Guidelines serve as a useful reference for taxpayers and tax authorities in conducting transfer pricing analyses. India has incorporated several recommendations from the OECD’s Base Erosion and Profit Shifting (BEPS) project into its domestic regulations, including the three-tier documentation structure and Country-by-Country Reporting (CbCR).

India has been actively involved in various action points of the OECD’s BEPS Action Plan and is engaging closely with other G20 member countries in this initiative. Notably, India’s transfer pricing authorities are aligning with the OECD’s approach on BEPS, particularly regarding intangible-related returns, ensuring that such returns reside with the entity responsible for strategic decision-making around the creation of intangibles.

Transfer Pricing and Digital Businesses

The rise of digital businesses has presented unique challenges for transfer pricing regulations. These businesses often have a limited physical presence but significant economic activity in a jurisdiction, making it difficult to apply traditional transfer pricing rules.

In response to these challenges, India has introduced measures such as the Equalisation Levy and the Significant Economic Presence (SEP) concept. The Equalisation Levy is a tax on payments for online advertising and digital advertising services provided by non-resident entities. The SEP provisions expand the definition of “business connection” to include digital businesses that operate in India without a physical presence, granting India taxing rights over such businesses.

Transfer Pricing Regulations in Related Jurisdictions

United States

The US transfer pricing rules are primarily governed by Section 482 of the Internal Revenue Code. These rules adhere to the arm’s length principle and require intercompany transactions to be priced as if they occurred between unrelated parties. The US regulations provide detailed guidance on various transfer pricing methods, including the CUP method, RPM, CPM, PSM, and Comparable Profits Method. The US also has robust documentation requirements and imposes penalties for non-compliance.

United Kingdom

The UK transfer pricing regulations are based on the arm’s length principle and are aligned with the OECD Transfer Pricing Guidelines. The UK has implemented the OECD’s three-tier documentation structure, requiring MNEs to maintain a Master File, Local File, and CbCR. The UK regulations also provide specific guidance on transfer pricing for intangible assets and financial transactions.

Singapore

Singapore’s transfer pricing guidelines are consistent with the OECD Transfer Pricing Guidelines. The Inland Revenue Authority of Singapore (IRAS) emphasizes the arm’s length principle and provides detailed guidance on comparability analysis and transfer pricing methods. Singapore also has documentation requirements and imposes penalties for non-compliance.

Comparison of Transfer Pricing Regulations